THE CASH MARKET IN AUSTRALIA
Bob Rankin
Research Discussion Paper
9214
December 1992
Domestic Markets Department
Reserve Bank of Australia
The analysis and views expressed in the paper are entirely those of
the author, and do not necessarily reflect those of the Reserve Bank
of Australia.
ABSTRACT
The cash market is the market for overnight loans between financial
institutions. This market is central to the operation of Australia's financial
system: it is there that banks seek to borrow or lend in response to shortterm fluctuations in their liquidity, and where the Reserve Bank conducts the
domestic market operations through which it controls monetary conditions
and implements monetary policy changes.
This paper outlines a model of the cash market in Australia, which
incorporates recent changes in the operating procedures followed by the
Reserve Bank. The paper shows how the dynamics of the cash market
depend on the presence of both same-day and next-day settlement in the
cash market, and how the various interest rates on overnight loans ("cash
rates") are determined.
TABLE OF CONTENTS
1. Introduction
2.
D d y Equilibrium
3.
Determination of Cash Rates
The Unofficial Cash Rate
The Official Cash Rate
4.
Conclusion
5.
References
THE CASH MARKET IN AUSTRALIA
Bob Rankin
1. INTRODUCTION
This note outlines a model of the Austrahan cash market. This is the market
where overnight interest rates are determined and where the Reserve Bank
conducts its market operations. An understanding of the structure and
operation of this market is helpful in analysis of the Reserve Bank's
implementation of Australian monetary policy.
The paper explains the structure of the market and the determination of
overnight interest rates (or "cash rates"). The analysis in the paper is based
on the Reserve Bank's present approach to monetary policy in which it
announces a target cash rate and operates to maintain rates close to the
announced target rate; however, the model itself is equally useful in
analysing the workings of the cash market prior to the adoption of this
approach in January 1990.1
There are two parts to the cash market:
the market for exchange settlement (ES) funds - those funds that can be
transferred for sarne-day value between accounts at the Reserve Bank and
used by banks to meet their daily ES obligations. Participation in this
market is restricted to the Reserve Bank and those institutions with
"same-day" accounts at the Reserve Bank: the banks (which have
exchange settlement accounts) and the authorised short-term money
market dealers (which have clearing accounts). Institutions in both groups
must keep their Reserve Bank accounts in credit at the end of each day there are no overdrafts permitted - and the Reserve Bank does not pay
interest on credit balances.
Earlier papers have examined the workings of the cash market at different stages of
its development: see Macfarlane (1984) and Dotsey (1991). A less technical
introduction to the cash market can be found in Battellino (1990) or Reserve Bank of
Australia (1990) .
The mainstay of this market is therefore the lending by banks of their
surplus ES funds to authorised dealers. Like all loans to authorised
dealers, these must be secured (if secured with Commonwealth
Government securities (CGS), the loans can be counted as PAR assets),
Banks also borrow and lend ES funds between themselves on an
unsecured basis in the interbank market at a rate of interest which tends to
be slightly higher than that on bank-dealer loans, reflecting the lack of
collateral.
Both banks and authorised dealers also transact in non-ES funds, both
with each other and with other non-bank institutions;
the market for non-ES funds (often called "next-day" or "bank-cheque"
funds). This part of the market deals in funds transferred by cheques paid
into an account at a commercial bank. These funds are cleared overnight
and give rise to ES obligations for banks on the next day. Banks,
authorised dealers and other non-bank institutions participate in this
market.
The interest rate paid by the authorised dealers on overnight ES loans from
banks is called the interest rate on ES funds. The interest rate paid by the
dealers on overnight loans in non-ES funds is the secured non-ES funds rate.
The weighted average of these two rates is called the official cash rate.
The interest rate on unsecured overnight loans of non-ES funds is called the
unofficial cash rate - this is generally higher than either of the two
components of the official cash rate, reflecting the lack of collateral.
Of the two markets, that in non-ES funds is the larger - there are no
statistics collected, but there could be $15 billion or more outstanding at any
time. The market in ES funds typically has about $2; billion outstanding.
The two markets are closely linked. Banks expecting to receive inflows
(respectively pay outflows) of ES funds tomorrow can either wait until
tomorrow and lend (respectively borrow) in the ES market then or they can
lend (respectively borrow)2 in the non-ES market today to offset tomorrow's
expected flows. In the latter case, the banks are using what is called "float"
- the amount which spills into the ES market tomorrow as a result of
transactions today. Banks' choice between the two options will be based on
a number of factors. One is a comparison of the non-ES rate today and the
expected ES rate tomorrow. More important is the level of ES balances that
each bank has - if high, the bank is likely to lend non-ES funds today so as
to avoid building ES balances up further; if low, the bank is likely to wait so
as to build up its ES balances and lend them in the ES market tomorrow.
Indeed, in the latter case, the bank may even seek to borrow non-ES funds
today to add to its ES surplus tomorrow.3
Authorised dealers facing a surplus (respectively deficit) today can meet this
by repaying loans (respectively borrowing) in either the ES or non-ES
markets today. In both cases they will balance their clearing accounts at the
Reserve Bank, but each will have a different implication for flows of ES cash
tomorrow. The decision will be based on comparing ES and non-ES interest
rates today.
Overall, the linkages between the two parts of the cash market create a
dynamic (or intertemporal) effect which is the key to understanding the
operation of the cash market as a whole.
2. DAILY EQUILIBRIUM
Although it is the smaller part, it is the ES funds market which is central to
an understanding of the operation of the overall market. It is here that the
In this context, "lend" should be taken to include buying securities and "borrow"
should be taken to include selling securities (either outright or under repurchase
agreements).
3 When a bank (say, Bank A) lends non-ES funds today to a party which is, or banks
with, another bank (say, Bank B), it must pay Bank B the "float" interest rate on this
amount overnight - as it does on all uncleared payments. This normally does not
affect the decision to lend, however, since Bank A will receive the float rate on the
same amount when the loan is repaid. The float rate is set each week as the average of
the official cash rate during that week. Banks settle for their net float payments each
month in arrears - as this example suggests, the netted payments tend to be quite
small given the large flows of funds that occur through the overnight clearings.
Reserve Bank operates, setting the parameters for the cash market as a
whole.
Daily equilibrium in the ES funds market requires that the demand for and
supply of ES funds to banks and authorised dealers are equated.
Supply of ES funds to banks comes from:
an opening surplus of the banking system - i.e. the net amount owed by
the Reserve Bank to other banks on account of the previous day's
transactions in non-ES funds involving the Reserve Bank and its banking
customers;4
sales of currency to the Reserve Bank (these are usually small, the
exceptions being immediately after Christmas and Easter holidays);
recall by banks of ES loans made in the past to authorised dealers;
rediscounts by banks of CGS at the Reserve Bank.
It should be noted that, while interbank loans of same-day funds d o exist,
they can only redistribute the supply between banks and cannot alter the
supply to banks as a group.
Sources of ES funds to authorised dealers are:
sales of CGS to the Reserve Bank in its dady operations at about 1030;
loans from banks transferred in ES funds;
sales of CGS to the Reserve Bank under late repurchase arrangements
after 1450.
This also includes some transactions in ES funds which were prearranged - e.g.
sales of foreign exchange to the Reserve Bank (which would have been arranged two
days in advance).
4
Demand by banks stems from:
an opening deficit of the system;
purchases of currency from the Reserve Bank (these are usually small, the
exceptions being immediately before Christmas and Easter holidays);
take-up of CGS won at tenders but not yet settled;
placement of new loans with authorised dealers;
leaving cash in exchange settlement accounts at the Reserve Bank.
Demand by authorised dealers stems from:
purchases of CGS from the Reserve Bank in its daily operations at 10:30;
take-up of CGS won at tenders but not yet settled;
recall by banks of past ES loans;5
leaving cash in clearing accounts at the Reserve Bank.
Also relevant are dealers' sales and purchases of securities, or loan
transactions in non-ES funds, with banks and non-banks.6 These sources all
provide or use non-ES funds, but are relevant to the ES market as the
Reserve Bank gives authorised dealers same-day value in their clearing
accounts for these transactions. Hence, the authorised dealers can offset a
potential surplus (respective shortage) of ES funds by creating a matching
shortage (respective surplus) in their transactions in non-ES funds.
Of all the uses of ES funds listed above, the options of leaving positive
balances in accounts at the Reserve Bank are rarely used in any significant
5 Authorised dealers are not permitted to make loans to other parties.
6 Banks do not lend non-ES funds to dealers directly, but can sell or buy securities
with them for non-ES payment, including under repurchase agreements.
degree, as the Reserve Bank pays zero interest on balances in these
accounts.7 All other uses pay a market return to the owner of the cash.
Equilibrium
Ignoring the options of leaving cash uninvested - i.e. in exchange
settlement accounts at zero interest - the equilibrium condition for the
official market can be represented algebraically for day t by:
where
St
=
net opening surplus of the market (negative if deficit)
net purchases of CGS by the Reserve Bank in its open market
operations and late repurchases (excludes unwinding repurchases,
which are included in St)B
0
=
Rt
=
rediscounts of CGS by banks
Tbt = take-up of newly-issued CGS by banks
Tdt = take-up of newly-issued CGS by authorised dealers
Lnt = net new loans to authorised dealers from non-banks
Bnt = net sales of securities by authorised dealers to banks and
non-banks
The net opening surplus of the market itself reflects a number of factors:
7 The Reserve Bank can at its discretion accept interest-bearing deposits from banks,
but these are rarely used.
8 If the Reserve Bank conducts. foreign exchange swap transactions in ES funds, they
would also be included in this term as their effect on the cash market is identical to
that of conducting transactions in repurchase agreements using CGS.
where
Gt-1 = net Government deficit on day t-1 arising from budget
transactions
Mnt-1 = maturities of and interest due on CGS paid to non-banks
on day t-1
Mbt
=
maturities of and interest due on CGS paid to banks
Mdt = maturities of and interest due on CGS paid to
au thorised dealers
Zt-2 =
day t-2
net sales of foreign exchange to the Reserve Bank on
=
net sales of Australian currency to the Reserve Bank
Nt
Udt = net repurchases of CGS by the Reserve Bank as a
result of past sales under repurchase agreements (negative if
resales)
Lnt-1 = net new loans in non-ES funds to authorised dealers
from banks and non-banks on day t-1
Bntml = net sales of securities by authorised dealers to banks and
non-banks on day t-1
Those items which appear dated t-1 are paid on day t-1 in non-ES funds and
affect ES on day t after being cleared overnight. Z is dated t-2 because
foreign exchange transactions are normally arranged two days before
settlement, with that settlement being effected in ES funds.
Substituting (2) into (1) yields:
The dynamics of daily equilibrium arise because of the presence of the term
L y l + By-1 in equation (3). This represents the net flow of non-ES cash
obtained by authorised dealers from banks and non-banks on day t-1, either
in the form of new loans or sales of securities. This net flow helped to
balance the sources and uses of cash on day t-1, but also spllls over to affect
the equhbrium of the cash market on day t.
Of the terms in equation (3), Gt.1, Mnc1, (Mbt+ Mdt), Udt ,Zt-2,Nt and (Lnt.1+
Bnt-1)are all predetermined, so the equation can be written:
where Xt = Gt-1+z-2+Nt+Mq-I+(M++Mq + Udt- (Lq-l+BY-l)
The intertemporal workings of equation (4) can best be illustrated with a
simple example. Assume that on day 1 X1, R1 ,and Tbl + Tdl are all zero i.e. the system starts off in balance, there are no rediscounts and there is no
take-up. Assume now that the Reserve Bank sells $100 mdlion worth of
securities to the authorised dealers in its daily operations - i.e. O1 = -100.
As there are no additional ES funds available, authorised dealers will need
to choose one of two options in response:
raise $100 million in non-ES funds to finance the purchase of the securities
from the Reserve Bank, either by raising new loans of $100 million or
selling securities worth $100 d i o n to banks or non-banks. In either case,
Ly + By = 100 and the cash market is in eqydibrium.
Assume for the moment that this is what the authorised dealers do. On
day 2, the spillover term from day 1 is (Ly + By) = 100 and, if all other
terms in X2, R2 , and Tb2 + Td2 are again assumed to be zero, banks will
have to pay the Reserve Bank $100 million in ES funds to settle their
overnight clearances and will call back this amount from authorised
dealers, in turn causing dealers to have to raise another $100 million from
non-banks. If the Reserve Bank does not purchase securities from the
dealers to offset this, L? + B? will be equal to $100m, and the banks will be
short $loom on day 3. The process would repeat on the third day, and so
on.
While the process continues, the level of banks' loans to authorised dealers
will decline by $100 million each day. This is offset by a combination of
rises in the level of dealers' borrowings in non- ES funds and rises in the
holdings of securities by banks or non-banks as dealers seek $100 rmllion
from non-banks each day. The result would be upward pressure on
interest rates and security yields, which would persist and even intensify
as the process went on from day to day;
sell CGS worth $100 d o n to the Reserve Bank under the late
repurchase facility. In this case, the value of Ot is reset to zero and the ES
market is in e w b r i u m .
When the late repurchase agreement expires (which couldbe next day), O t
will have a value of -100 if the Reserve Bank does not do any other
dealing. Authorised dealers will then have to raise another $100 rmllion
from non-banks on that day, and the opening situation on day t is
replicated.
Hence, use of the late repurchase facility merely postpones the need for
other adjustments of the type outlined in the first option.
Of course, in practice the Reserve Bank would not allow the adjustment
process to continue until banks' ES loans to authorised dealers became too
low. During t h s process, interest rates on cash and securities will change as
demand by and supply from the authorised dealers and banks change from
day to day (the ways in which this occurs are discussed in some detail in
Section 3 below). But the Reserve Bank has announced targets for cash rates
- in order to keep to that target rate, the Reserve Bank would remove the
imbalance by stepping in to inject cash through its market operations if no
injection occurred from exogenous sources (e.g. from a Government deficit)
or from rediscounts by banks (if cash rates rose to the point where
rechscounts were cost-effective). Nevertheless, what this market structure
does provide is a high degree of leverage by the Reserve Bank over the
market and hence it ensures that the Bank has the power to move the cash
market quickly backward or forward, as the case may be, should there be
some disturbance to cash rates caused by one of the exogenous factors in
e ~ a t i o (4).
n
3. DETERMINATION OF CASH RATES
In practice, the official and unofficial cash rates are determined
simultaneously by a complex interplay of demand and supply for the
different categories of cash. Further, as both ES and non-ES loans are used
by market participants to fund holdings of securities, typically of fairly short
maturities, changes in demand for or supply of cash will affect the
demand/supply balance in markets for these securities. Yields on these
securities will be determined simultaneously with cash rates and will, in
general, reflect expectations about the levels of cash rates over the term of
the securities.
In this section, however, the determination of cash rates is presented using a
partial equilibrium approach which brings out the key linkages between the
different parts of the market. It first outlines the workings of the unofficial
cash market and the determination of the unofficial cash rate. It then shows
how the official cash rate is determined, taking the unofficial rate as g-lven.
The Unofficial Cash Rate
As indicated by the model in Section 2, it is movements in non-ES loans to
authorised dealers and the broader market for securities which play the
pivotal role in the adjustment of the market in ES funds to changes in ES
cash flows. When the level of non-ES loans to authorised dealers changes, it
adds to or subtracts from the availability of non-ES funds in the wider
unofficial market.
Under its present operating procedures, the Reserve Bank announces a
target level for cash rates. In practice, it is the unofficial cash rate which is
targeted by the Bank (though, as explained later, the unofficial and official
cash rates are about equal). The unofficial cash rate fluctuates from day to
day but the Bank acts to keep it fairly close to the announced target. Market
participants will expect the unofficial cash rate to equal the target rate on
average in the future until a new target is announced.
Demand for non-ES funds is likely to be highly elastic at the Reserve Bank's
announced target interest rate. Above that rate, demand will fall steeply as
the loan rate approaches the late repurchase rate (at which dealers can
obtain cash from the Reserve Bank) or the rediscount rate - the late
repurchase rate is normally the lower of the two and in practice is often
equal to the announced target rate for unofficial cash. Below the announced
target rate, demand will rise steeply as participants try to take advantage of
what they expect to be a temporary low cost of funds.
Supply will be positively related to the unofficial cash rate, but it too is likely
to be fairly elastic in the vicinity of the announced target rate. Because
participants expect rates to remain close to the target rate, they will be
willing to lend considerably more for a small rise in returns and, conversely,
wdl curtail lending quickly i f rates were to fall by a small amount.
Graphcally, this can be represented by:
Figure 1: The Unofficial Cash Market
Unofficial
Cash Rate
S'
r*
,
D
re
S
D'
Loans
~e
In Figure 1, DD' represents the demand for non-ES loans and SS' the supply
of these loans. Both curves are relatively flat at around F,the announced
target interest rate; r* is the late repurchase rate, at which dealers would
cease to bid in the market for non-ES funds and instead would sell CGS to
the Reserve Bank under repurchase arrangements to raise cash.
It should be emphasised that the shapes of the supply and demand curves
depend on perceptions in the cash market that the Reserve Bank will take
action to keep cash rates close to the announced target rate re and about
where the Bank will choose to set the late repurchase rate.
This model can be used to analyse the effect on the unofficial cash rate of a
one-off sale of CGS by the Reserve Bank, as shown in Figure 2.
Figure 2: The Unofficial C a s h Market
Unofficial
D,/
demand curve moves right
by amount of RBA sale
S'
S
Dl'
Loans
L, L2e
The sale of securities by the Reserve Bank causes a rightward shift in the
demand curve for non-ES loans, from DIDll to D2D2rfas authorised dealers
enter the market to fund the CGS they have bought from the Bank. The
equilibrium level of loans rises from L1e to L2e and the equilibrium unofficial
cash rate rises from rle to rze.
The next day, the spillover effect discussed in Section 2 would cause the
demand curve to move right again by L2e - Lle. This process would continue
from day to day while the authorised dealers were substituting non-ES
funds for ES funds in their stock of loans.
It is clear from this analysis that the Reserve Bank would have to sell a large
amount of CGS to cause a significant rise in the unofficial cash rate.
Alternatively, it would have to sell a smaller amount and allow the effects to
keep sp~llingover for several days, with the cash rate rising from day to day.
However, this results from a set of demand and supply relationships which
are based on the expectation that the Reserve Bank does not want to move
the cash rate by a significant amount, but in fact wants to keep it within a
narrow range. When the Bank does want the rate to move, it announces a
new target which causes the curves to reshape, with their elastic segments at
the new target rate, because the market knows that the Bank will seek to
manage the flows of ES funds to clear the non-ES market at that rate.
Indeed, having announced a new target, there may be very little need in
practice for the Bank to buy or sell CGS to add pressure for the cash rate to
move close to the new target.
The Official Cash Rate
As noted in Section 2 above, there are few uses for ES cash in the hands of
banks which are surplus to their needs for exchange settlement. Banks can
use them to make deposits with the Reserve Bank (generally at low or zero
interest), to purchase notes and coin, to purchase CGS previously won at
tender but not yet taken up, or to make loans to authorised dealers. Only the
last two offer a market return on the funds, and of those the former is not
always available.
Banks are willing to lend their ES funds to authorised dealers at less than the
unofficial cash rate, for two reasons:
the presence of a captive market element, reflecting the relative lack of
opportunities for banks to invest ES funds;
banks' loans to authorised dealers are secured, either by CGS (attracting a
concessional risk weighting for capital adequacy purposes and included in
PAR) or other securities.
The official cash rate is the average rate paid by authorised dealers on all
their loans. From an authorised dealer's point of view, ES loans from banks
and loans of non-ES funds from banks or others are very close substitutes both can be used to square the dealer's clearing account. As a result, dealers'
demand for ES loans is highly interest-elastic.
The market for official cash can be represented graphically as follows:
Figure 3: The ES Cash Market
Cash
I
Loans
Be
where
ru represents the unofficial cash rate
rd represents the rediscount rate
Be represents the surplus ES available to banks.
In Figure 3, the SS curve is drawn as vertical at loan rates below rd. This
would be the case if there are no CGS previously won at tender by banks but
not yet taken up. If banks have such CGS available to be taken up, they
might use some ES for this purpose if the loan rate falls sufficiently and the
SS curve may kink to the left at some point.
To determine the official cash rate, it is necessary to know re, ru and the
proportions of loans to authorised dealers in ES and non-ES funds.
Generally, the proportion in ES loans is large - 80 per cent is not unusual so the official rate is dominated by the rate in the ES part of the market.
Loans of ES funds between banks on the interbank market are generally at a
rate slightly higher than the rate on ES loans to dealers, because the
interbank loans are unsecured.
In Figure 3, the rate on ES loans will be re, which is less than ru as the
demand curve for ES funds is always below that point. If ES funds are in
plentiful supply, re may be considerably below the unofficial cash rate but
typically the margin is around 10 basis points (0.1 percentage point). In such
a state, however, banks which held high levels of ES loans to authorised
dealers would be much more willing to lend non-ES funds in an attempt to
run down their ES holdings - this would tend, in terms of Figure 1, to shift
the demand curve for non-ES loans to the left and the supply curve to the
right. In the absence of some offsetting withdrawal of ES funds from the
market the plentiful supply of ES funds would flow through to lower
unofficial cash rates and the normal margin between official and unofficial
rates would tend to be restored. Of course, if the unofficial rate were to fall
too far below the Reserve Bank's announced target rate, the Bank would
step in to remove ES funds and reverse the process.
4. CONCLUSION
This paper has presented a simple model of the workings of the Australian
cash market, illustrating the key features of the same-day/next-day nexus
on which the dynamics of the market depend and the impact of changes in
cash flows on cash rates.
The model presented here reflects the contemporary structure of the market
- in particular, it embodies the Reserve Bank's post-January 1990 approach
of announcing changes in monetary policy in the form of new target levels
for cash rates. Under this operating regime, cash rates have generally been
within quite narrow bands around the announced target rates.
There are, of course, some shortcomings of a simple model like the one
presented here. One important one is that the model makes it look too easy
to keep cash rates at their target levels. In fact, there have been occasions
when cash rates have risen sharply above the announced target levels for
short periods. The model presented in t h s paper suggests that this would
occur if there was a very large outflow of ES cash but even then the safety
valves - the late repurchase facility for authorised dealers and the
rediscount fachty - should limit the scope for cash rates to rise.
These safety valves - indeed, the whole of the Reserve Bank's intervention
in the market - depend on the ready availability of CGS to sell to the Bank.
There are times when friction in the market, associated with the existence of
credit and dealing limits between counterparties, makes it difficult to
transfer holdings of securities - and hence access to cash - to the parties
that need it. Of course, like all frictional effects, these tend to be short-lived
and even then the resulting fluctuations in cash rates are of a smaller order
of magrutude than occurred under past operating regimes.
Another reason why cash rates might move u p sharply stems from each
bank's desire to keep its level of ES balances above a minimum "comfort"
level. If ES balances fall to this level, the bank will curtail its non-ES lending
and begin to borrow non-ES funds in the unofficial market, with the aim of
building up its ES levels the next day. If the overall level of ES balances is
very low, many banks will be trylng to do this simultaneously and, in terms
of Figure I, the supply curve for non-ES funds will move to the left and the
demand curve will move to the right - a sizeable increase in the cash rate is
likely. Of course, this cannot increase the overall level of ES balances
available to banks - at most, it just changes the distribution between banks
- but the resulting increase in the cash rate would be enough to induce the
Reserve Bank to inject ES so as to return cash rates closer to their announced
target level. Initially, this would depress the official cash rate but within a
few days would also work through to the unofficial rate by reversing the
shift in the demand and supply curves for non-ES funds.
REFERENCES
Battellino, R. (1990), "The Reserve Bank's Domestic Market Operations." In
The Reserve Bank and the Market Place, Reserve Bank of Australia, Sydney.
Dotsey, M. (1991), "Open Market Operations in Australia:
Perspective." Economic Record, 67: 243-256.
A US
Macfarlane, I.J. (1984), 'Methods of Monetary Control in Australia." Paper
presented to the New Zealand Association of Economists Annual
Conference, Massey University. Reprinted in D.J. Jiittner and T. Valentine
(eds), The Economics and Management of Financial Institutions, Longman
Cheshire, Melbourne, 1987.
Reserve Bank of Australia (1990), "The Reserve Bank's Domestic Market
Operations", Reserve Bank of Australia Bulletin, December.